Volume 60
October 2015
Capital markets are known for “reverting to the mean”, which is one reason why we have
been predicting, since mid-summer, that the markets were overdue for a period of dramatic
downside volatility. That prediction was proven quite
prescient in the third quarter, when the equity markets
followed the least volatile six months in U.S. market history
(early February through mid-August) with the highest statistical
volatility (and the biggest quarterly losses) since 2011.
With third quarter losses in the major domestic equity indexes
ranging from 6.9% to 9.3%, and losses in Western European
equity indices averaging 9.0%, these two regions actually
offered a relative “shelter from the storm”. In contrast, the
world’s emerging equity markets, on average, suffered a
quarterly decline of 18.7% (their worst quarter since 2008).
The S&P Latin America 40 Index dropped by a dramatic
24.1% during the quarter and the S&P Asia 50 Index plummeted a similarly remarkable
17.6%. The Japanese and Chinese stock markets fell by 14% and 25% respectively.
As a result of this decline, the equity markets of the United States, Switzerland, Italy, India,
Canada, the United Kingdom, France, Japan, and Spain have now declined between 10%
and 20% from their recent highs (a “correction”), while the stock markets in China,
Germany, Portugal, Argentina, Brazil, Hong Kong, Russia, and Greece are all down at least
20% from their recent highs
(the definition of a bear
market).
Even as bearish as our
commentary has been over
recent months, the global
reach of this correction has
surpassed even our
expectations, which begs the
question of whether or not
this is now the time to step in
and start taking advantage of
the recent carnage. At bare
minimum, we believe that the
time has come to step back
from the proverbial “ledge”, sit down at your desk, and start making your shopping list.
On one hand, we are still waiting to see a few things fall in place before making a highconviction call that the ultimate lows have already been reached. On the other, you will see
from the following list of elements that normally occur in conjunction with a market bottom
that this correction has already checked most of the boxes.
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The first requisite for most market bottoms is the existence of extreme levels of bearish
sentiment. This is based upon the premise that, if you are bearish (i.e. you are confident that
the market is due to decline), you have already sold your shares. It therefore follows that, if
bearish sentiment is very high (or bullish sentiment very low), then most potential sellers
have already sold and very few potential
buyers have already bought. This normally
translates into high levels of sideline cash,
and an environment with significant upside
potential and reduced levels of downside
risk.
There are a number of ways in which
analysts measure market sentiment. One of
the most useful is the Investor’s Intelligence
Bull/Bear Survey of investment newsletter
writers. This survey, which divides
newsletter writers into three categories (bull,
bear, and neutral), provides a very useful
perspective due to its leveraged nature. In other words, because each newsletter can help
form the market opinion of thousands of subscribers, it helps to measure the market
sentiment of a very large sample size. At this point, bullish sentiment is as low as it has been
since the depths of the financial crisis in 2009.
Further insight into the sentiment of the individual investor can be found through the
American Association of Individual Investors (AAII) Bull/Bear Survey, which reflects
expectations for six months into the future. The results of the most recent AAII survey
(9/30/15) show a massive 11.2% jump in bearish sentiment, which is quite bullish from a
contrarian point of view. To put these sentiment numbers into some perspective, the longterm average for bullishness is 38.8%, for bearishness is 30.3% and for neutral is 31.0%, so
you can see that bearish sentiment is approximately 32% higher than normal. Indeed, AAII
bullish sentiment readings have now fallen for the 30th consecutive week, which is the
longest such streak in the survey’s history.
Moreover, over the past three
months, investors have pulled
$63 billion out of domestic
equity mutual funds, which
represents the biggest quarterly
withdrawal in the past 30 years.
Indeed, in the latest Investor’s
Intelligence Survey of Financial
Advisors, only 25% said that
they were bullish on U.S.
equities, which means that
there are fewer bulls now than there were in March of 2009, when the Standard & Poor’s
500 Index reached its bear market low of 666, and only slightly more bulls now than when
the survey showed only 22% bulls immediately after the collapse of Lehman Brothers, when
there were broad concerns about a potential collapse of the entire financial system.
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All of this suggests to us that the selling has become irrationally extreme, that the vast
majority of potential sellers have already sold, and that very few of the potential buyers have
started deploying their sideline cash. While only time will tell if the ultimate low for this
corrective phase has already been reached, we currently view the market as having significant
upside potential coupled with somewhat limited downside risk.
In addition to excessive levels of bearish sentiment, one of the key components of most
market bottoms is a successful retest of the initial reaction lows. This is something that we
wrote about extensively in
the September edition of this
publication, when we
illustrated that in seven of
the previous eight times
(dating back to 1934) that the
domestic markets have
experienced such a short,
sharp correction, the market
required a successful retest of
the initial reaction lows (i.e. a
double bottom) before they
could make a sustained move
higher.
As you can see from the
chart of the Russell 3000
Index (which includes the
3000 largest domestic
stocks), an apparently successful retest of the initial reaction lows has now taken place, and
an attempt at a strong rebound is now underway.
Another factor that has turned in the favor of the bulls is the seasonal patterns that have
been remarkably consistent in the past. Indeed, the most bullish six months of the year have
historically taken place between mid-October and mid-April. According to the Stock
Trader’s Almanac, the Dow Jones Industrial Average has, since 1950, averaged gains of 7.6%
from November through April whereas, during the May through October period, it has only
averaged gains of 0.3%. The relationship is even more dramatic if you measure from midOctober through mid-April.
There are a variety of reasons for this phenomenon, most of which are related to taxes. For
example, because most mutual funds conclude their fiscal year in October, there is a
tendency to sell losing positions in October to help offset the capital gains that they must
otherwise distribute to their shareholders. These trades must settle by the end of the fiscal
year, so there is a historic tendency for the first two weeks of October to be quite weak. We
have a particular concern about tax-related selling this year, as fund managers may decide to
sell as much as is necessary to offset all taxable gains, in order to prevent the need to present
shareholders with a tax liability in a year when they are also likely to lose money. Among the
other reasons for this seasonal tendency are the end of prior-year IRA contributions on
April 15th, required minimum distributions (RMD) from IRAs and qualified plans, and the
need to withdraw money from the markets in April in order to pay taxes.
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From a seasonal perspective, this has been a textbook correction, as the third quarter is
justifiably known as a period of violent sell-offs in the equity markets, and October is
appropriately known as
the month of major
stock market bottoms.
Of note, it was in
October that the critical
retest of the initial
reaction lows took place
after the market
corrections in 1990,
1998, and 2011.
A point of at least some
concern to us is that,
unlike in 2015, these
(and many other retests)
actually violate the initial
lows. While it may seem
nitpicky, history suggests
that a violation of the
initial lows is usually
very important, as it is
the violation of such a
perceived area of
support that tends to
cause the capitulation
selling that forces the
last potential sellers
from the market and
puts in place the
ultimate bottom.
For the record, we do
believe that it is most
likely that we have seen
the lows for this healthy
and very necessary
correction, and that this
will prove to be an
excellent long-term
buying opportunity.
However, without the existence of a high-volume, capitulation-type sell-off to confirm that
the selling is, in fact, exhausted, we do have to allow for the possibility of another retest later
in the month, particularly once the tax-related selling by mutual funds hits its stride. As
strange as it may sound, we would have been happier to see a breach of the initial lows and
the resulting bout of panic selling. Without that confirmation, it will take some time to
confirm the existence of a sustainable bottom.
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We will use the VIX fear gauge to illustrate our point. This tool measures fear as a function
of how much investors are willing to pay for defensive hedges. As such, it is a great measure
of the sentiment of professional traders. It is also an indication of how many “short”
positions there are in the market, which is important, as traders are going to need to “cover”
their shorts by buying the underlying stocks in the event of a rally.
The good news is that
the markets tend to
perform very well in
the one and threemonth periods after the
VIX rises above the 20
level, which it just
recently blew through.
The less than ideal
news is that, while the
spike in fear associated
with the initial low (red
arrow) was a classic
example of how this
index performs at a
major market bottom,
there was much less
fear associated with the
retest, which suggests
that there may still be
some pent-up selling
pressure. If so, we
suspect that it will be
resolved over the very
near term, after which
we expect for the
bullish seasonal
patterns to take hold.
We started this report
talking about the tendency towards mean reversion in the capital markets, and applied this
concept to this year’s volatility in the equity markets. We would like to return to this
concept, but to apply it instead to both short and long-term market returns. In regards to
short-term (i.e. quarterly) returns, Bespoke Investment Group just produced a study showing
both that weak third quarters are normally followed by strong fourth quarters, and that, with
the notable exceptions of 1937 and 1957, the weakest third quarter returns were followed by
the strongest fourth quarter rebounds.
If you apply the same concept to longer-term (15-year average) returns, you will find that,
with an average annual return of only 3.76%, the new millennium has not been kind to
investors. In contrast, if you also use 1945 as a start date, the actual average annual return
for the Standard & Poor’s 500 has been 10% per annum, which shows just how substandard
recent returns have been.
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If you accept the premise of mean reversion, this should actually be interpreted as good
news, as it suggests that the next 15 years should be much stronger than average. While this
theory tells you virtually nothing
about what is likely to happen
over the remainder of October,
it does provide yet another
argument for taking the
opportunity of the recent sell-off
to purchase equities with a
longer-term perspective in mind.
Regardless of whether the
ultimate lows for this decline are
already in place, or if we will still
see more short-term volatility,
there are a variety of other
factors that give us reason to
turn fairly bullish at this point.
To start with, the global equity
markets actually sold off on the Federal Reserve’s decision not to raise rates in September.
This is a 180 degree turn from recent history, when investors would panic whenever anyone
from the Fed
even talked about
either ending their
quantitative easing
programs or
raising interest
rates. This
suggests to us
that, while not
reflected in the
Fed Funds futures
market yet,
investors have
adjusted to the
inevitability of a
rate increase,
which should
make a rate hike
much less
dangerous.
We were also impressed by the market’s reaction to the terrible employment numbers on
October 2nd. After selling off very hard initially, equities responded with the biggest upside
reversal in four years. Few things in the investing world are more bullish than a market that
rallies strongly in the face of bad news.
Whether we have seen the ultimate low or not, we believe that history will view current
prices as an attractive entry point for equity investors.
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